The economics of uncertainty

The research focus on market uncertainty has been strong since the Great Recession. One of the key themes in finance over the last five years has been Risk-on/Risk-off (RO/RO) trading. There has been a strong focus on the VIXX index as an indicator of counter-cyclical market moves. It is only natural that there has been a deep focus on uncertainty by academic researchers over this period.

Though we knew most of this, the research has re-enforced these key relationships. From all of this work we can conclude a few things about uncertainty:

1. Macro and micro uncertainty increases during a recession.
 - The VIXX index of stock volatility will increase during a recession and will be negatively related to stock market declines.
-  The number of newspaper stories on uncertainty will increase in a recession usually because recession are preceded by large macro shocks.
- The dispersion of macro-forecasts will increase during a recession. Forecasters do not do a good job of forecasting turning points in the economy. They only do well at extrapolating trends.
- On the microeconomics side, there is an increase in dispersion of growth across industries during a recession. When the economy slows, marginal business will deviate from market leaders.
- There is an increase in sales dispersion within industries. It is harder to do business in a recession and poorly managed firms will be more hurt more.
- EM economies have more uncertainty based on divergence of forecasts and other macro measures.

2. Uncertainty leads to a delay in decisions. We can think of most business decisions as real options. If there is more uncertainty about a decision, it pays to delay or not exercise the option to act.

3. Uncertainty is counter-cyclical.
-Wages and income volatility is counter-cylical

4. Risk premia go up when there is more uncertainty. Investors have to be compensated for the uncertainty they face.
- Investors and businesses have ambiguity aversion. When it is hard to even make a forecast or provide good estimates of the extreme in a distribution, investors will avoid making any decision. Just hold cash.